The manipulation of Libor and foreign exchange rates by traders has led to an unprecedented outcry and an onslaught of regulatory probes. But the losses suffered by investors pale into insignificance compared with those they have endured through their exposure to cap-weighted indices.

Pensions scandal

The annual drag on the performance of pension schemes across the world as a result of their construction could total tens of billions a year.

The thousands of cap-weighted indices littered across the world include renowned brands such as the S&P 500, FTSE All Share and MSCI World.

They are compiled according to the market valuation of companies, providing an easy reference point for size. Based on earnings forecasts rather than turnover, and biased to growth stocks, they facilitate the raising of capital, which banks like. The bias to large companies means cap-weighted indices are liquid, which traders like.

But they were never designed to serve the interests of investors. Princeton University professor Burton Malkiel famously observed in 1973 that a blindfolded monkey throwing darts at share prices listed in financial newspapers had a decent shot at outperforming them.

The inefficiency of cap-weighted indices infuriates Tim Gardener, global head of consultant relations at Axa Investment Managers. And not just because he likes the smarter lists manufactured by his firm. I recall he was pretty dubious on the merit of cap-weighted indices back in the late 1980s when he led Mercer’s global investment business.

In those days, following euphoria in Tokyo, Japanese equity values were nearly half the global total. Gardener recommended his clients to avoid the overweight and split their equity portfolios equally between Europe, North America and Asia.

A global version of this index would have beaten the MSCI by two percentage points a year since 1989, according to back-testing.

Gardener says: “This has consequences for passive investors. It also suggests active managers have been given an incredibly low hurdle to jump.”

He argues managers could have also improved their performance by two percentage points if clients had provided a better list of weightings than those contained in cap-weighted indices. This would imply a drag worth tens of billions of dollars on a global pension scheme movement worth upwards of $30 trillion.

Problems are compounded when active managers become reluctant to stray too far from the index for fear of losing their fee income.

Some of the tedious larger stocks that managers feel obliged to own include those that are highly placed in indices by having a huge number of shares in issue, as opposed to good prospects.

Telecom stock Vodafone weighed down portfolios for more than a decade, following its 1999 mega-bid for Mannesmann of Germany. It finally sputtered back into life last year, by which time many investors had capitulated.

Financial stocks, not the best bet of recent years, comprise a fifth to a quarter of cap-weighted indices. The domestic Chinese A50 exchange-traded fund launched by Source last week has a staggering 65% weighting in financials.

Worse, when would-be growth stocks within the indices have raised their acquisition finance, cap-weighted investors need to live with subsequent disappointments. Again, think Vodafone. Or, if you happen to be French, Vivendi. Or, if you are American, Microsoft.

Axa Rosenberg is one of several firms who use a systematic approach to avoid the influence of cap-weighted indices. They have beaten them by an annualised one to two percentage points over the long term. Such managers include Dimensional Fund Advisors and Intech. Providers of alternative exchange-traded funds have also invaded the space.

Indices compiled by Rob Arnott’s Research Affiliates use weightings in line with corporate fundamentals. They have outperformed for years (see chart).

APG, manager of the Dutch civil service pensions scheme, customises its strategies to avoid cap-weighted bias. The tweaks have added 50 basis points to performance over three years.

We need to take a look at research by Eugene Fama, who won the 2013 Nobel prize for economics, and his associate Ken French.

Fama has proved the price of stocks is primarily driven by market-related sentiment, known as beta, which is fairly obvious. But this market-driven sentiment drags money away from stocks that lurk in the shadows.

Fama found small-cap stocks outperformed their larger brethren over time, as their prices caught up with the mainstream. He found that value stocks, priced below their book worth, also tended to do well. More recently, Fama found that companies that sustain profitable records, after stripping out accounting adjustments, also outperform.

If you cut through the marketing spiel, in fact, just about any product that isn’t driven by cap-weighted indices outperforms.

Even the monkey throwing darts can outperform because a clear majority of stocks listed in the financial pages are small-cap or value stocks. Its approach isn’t smart, but it is smarter than cap-weighting.

There is, sadly, no such thing as a free lunch. As Fama has pointed out, investors backing value and small-cap investments run the risk of periodic underperformance.

Even the sleepiest large cap can outperform when it is cheap enough. Portfolios tilted to small-cap value stocks have only beaten the cap-weighted market two thirds of the time since 1930.

The credit crisis was also bad news for active quant managers who used leverage to overpay for some alternatives to cap-weighted indices, which had looked safe before the crisis.

As James Montier, senior strategist with asset manager GMO, has said: “Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one.”

APG of the Netherlands concedes big moves in favour of alternative indices could dilute smart returns, one day. But it believes its approach will reward the Dutch civil service for some time to come.

Consultants Mercer, Towers Watson and Aon Hewitt have given diversification away from cap-weighted indices their blessing. And managers are less frequently obliged to track a cap-weighted index than in the past.

For the record, consultants are smarter than asset managers like to pretend. And investors who fail to acknowledge the risks lurking within portfolio benchmarks risk being incredibly stupid.

--This article first appeared in the print edition of Financial News dated January 13, 2014